1. The Fundamentals of Managerial Economics
Chapter 1
The Fundamentals of Managerial Economics
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Learning Objectives
Summarize how goals, constraints, incentives, and market rivalry affect economic decisions.
Distinguish economic versus accounting profits and costs.
Explain the role of profits in a market economy.
Apply the five forces framework to analyze the sustainability of an industry’s profits.
Apply present value analysis to make decisions and value assets.
Apply marginal analysis to determine the optimal level of a managerial control variable.
Identify and apply six principles of effective managerial decision making.
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Introduction
The Manager
A person who directs resources to achieve a stated goal.
Directs the efforts of others.
Purchases inputs used in the production of the firm’s output.
Directs the product price or quality decisions.
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Introduction
Economics
The science of making decisions in the presence of scarce resources.
Resources are anything used to produce a good or service, or achieve a goal.
Decisions are important because scarcity implies trade-offs.
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5. Managerial Economics Defined
Introduction
Managerial Economics Defined
The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.
Should a firm purchase components – like disk drives and chips – from other manufacturers or produce them within the firm?
Should the firm specialize in making one type of computer or produce several different types?
How many computers should the firm produce, and at what price should you sell them?
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6. Economics of Effective Management
The Economics of Effective Management
Economics of Effective Management
Basic principles comprising effective management:
Identify goals and constraints
Recognize the nature and importance of profits
Understand incentives
Understand markets
Recognize the time value of money
Use marginal analysis
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7. Identify Goals and Constraints
The Economics of Effective Management
Identify Goals and Constraints
Well-defined goals
Firm’s overall goal is to maximize profits
Constraints make it difficult to achieve goals
Available technology
Prices of inputs used in production
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8. Recognize the Nature and Importance of Profits
The Economics of Effective Management
Recognize the Nature and Importance of Profits
Accounting profit
Total amount of money taken in from sales (total revenue) minus the dollar cost of producing goods or services.
Economic profit
The difference between total revenue and cost opportunity cost.
Opportunity cost
The explicit cost of a resource plus the implicit cost of giving up its best alternative.
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9. Recognize the Nature and Importance of Profits
The Economics of Effective Management
Recognize the Nature and Importance of Profits
The role of profits
Profits are a signal to resource holders where resources are most highly valued by society.
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10. Five Forces and Industry Profitability
The Economics of Effective Management
Five Forces and Industry Profitability
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11. Understand Incentives
The Economics of Effective Management
Understand Incentives
Changes in profits provide an incentive to how resource holders use their resources.
Within a firm, incentives impact how resources are used and how hard workers work.
One role of a manager is to construct incentives to induce maximal effort from employees.
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The Economics of Effective Management
Understand Markets
Two sides to every market transaction: buyer and seller
Bargaining position of consumers and producers is limited by three rivalries in economic transactions:
Consumer-producer rivalry
Consumer-consumer rivalry
Producer-producer rivalry
Government and the market
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13. Recognize the Time Value of Money
The Economics of Effective Management
Recognize the Time Value of Money
Often a gap exists between the time when costs are borne and benefits received.
Managers can use present value analysis to properly account for the timing of receipts and expenditures.
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14. Present Value Analysis 1
The Economics of Effective Management
Present Value Analysis 1
Present value of a single future value
The amount that would have to be invested today at the prevailing interest rate to generate the given future value:
𝑃𝑉= 𝐹𝑉 1+𝑖 𝑛
Present value reflects the difference between the future value and the opportunity cost of waiting:
𝑃𝑉=𝐹𝑉−𝑂𝐶𝑊
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15. Present Value Analysis II
The Economics of Effective Management
Present Value Analysis II
Present value of a stream of future values
𝑃𝑉= 𝐹𝑉 𝑖 𝐹𝑉 𝑖 2 +…+ 𝐹𝑉 𝑛 1+𝑖 𝑛
or,
𝑃𝑉= 𝑡=1 𝑛 𝐹𝑉 𝑡 1+𝑖 𝑡
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16. The Time Value of Money in Action
The Economics of Effective Management
The Time Value of Money in Action
Consider a project that returns the following income stream:
Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000.
At an annual interest rate of 3 percent, what is the present value of this income stream?
𝑃𝑉= $10, $50, $100, =$148,352.70
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The Economics of Effective Management
Net Present Value
The present value of the income stream generated by a project minus the current cost of the project:
𝑁𝑃𝑉= 𝐹𝑉 𝑖 𝐹𝑉 𝑖 2 +…+ 𝐹𝑉 𝑛 1+𝑖 𝑛 − 𝐶 0
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18. Present Value of Indefinitely Lived Assets
Economics of Effective Management
Present Value of Indefinitely Lived Assets
Present value of decisions that indefinitely generate cash flows:
𝑃𝑉 𝐴𝑠𝑠𝑒𝑡 = 𝐶𝐹 0 + 𝐶𝐹 𝑖 𝐶𝐹 𝑖 𝐶𝐹 𝑖 3 +…
Present value of this perpetual income stream when the same cash flow is generated (𝐶𝐹 1 = 𝐶𝐹 2 =…=𝐶𝐹):
𝑃𝑉 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = 𝐶𝐹 𝑖
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19. Present Value and Profit Maximization
Economics of Effective Management
Present Value and Profit Maximization
Profit maximization
Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits.
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20. Present Value and Estimating Values of Firms I
Economics of Effective Management
Present Value and Estimating Values of Firms I
The value of a firm with current profits 𝜋 0 , with no dividends paid out and expected, constant profit growth rate of 𝑔 (assuming 𝑔<𝑖) is:
𝑃𝑉 𝐹𝑖𝑟𝑚 = 𝜋 0 + 𝜋 0 1+𝑔 1+𝑖 𝜋 𝑔 𝑖 𝜋 𝑔 𝑖 3 +…
= 𝜋 𝑖 𝑖−𝑔
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21. Present Value and Estimating Values of Firms II
Economics of Effective Management
Present Value and Estimating Values of Firms II
When dividends are immediately paid out of current profits, the present value of the firm is (at ex-dividend date):
𝑃𝑉 𝐹𝑖𝑟𝑚 𝐸𝑥−𝑑𝑖𝑣 = 𝑃𝑉 𝐹𝑖𝑟𝑚 − 𝜋 0
= 𝜋 𝑔 𝑖−𝑔
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22. Short-Term versus Long-Term Profits
Economics of Effective Management
Short-Term versus Long-Term Profits
Short-term and long-term profits
If the growth rate in profits is less than the interest rate and both are constant, maximizing current (short-term) profits is the same as maximizing long-term profits.
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Economics of Effective Management
Use Marginal Analysis
Given a control variable, 𝑄, of a managerial objective, denote the
total benefit as 𝐵 𝑄 .
total cost as 𝐶 𝑄 .
Manager’s objective is to maximize net benefits:
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄
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Economics of Effective Management
Use Marginal Analysis
How can the manager maximize net benefits?
Use marginal analysis
Marginal benefit: 𝑀𝐵 𝑄
The change in total benefits arising from a change in the managerial control variable, 𝑄.
Marginal cost: 𝑀𝐶 𝑄
The change in the total costs arising from a change in the managerial control variable, 𝑄.
Marginal net benefits: 𝑀𝑁𝐵 𝑄
𝑀𝑁𝐵 𝑄 =𝑀𝐵 𝑄 −𝑀𝐶 𝑄
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Economics of Effective Management
Use Marginal Analysis
Marginal principle
To maximize net benefits, the manager should increase the managerial control variable up to the point where marginal benefits equal marginal costs. This level of the managerial control variable corresponds to the level at which marginal net benefits are zero; nothing more can be gained by further changes in that variable.
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26. Marginal Analysis In Action
Economics of Effective Management
Marginal Analysis In Action
It is estimated that the benefit and cost structure of a firm is:
𝐵 𝑄 =250𝑄−4 𝑄 2
𝐶 𝑄 = 𝑄 2
Find the 𝑀𝐵 𝑄 and 𝑀𝐶 𝑄 functions.
𝑀𝐵 𝑄 =250−8𝑄
𝑀𝐶 𝑄 =2𝑄
What value of 𝑄 makes 𝑁𝑀𝐵 𝑄 zero?
250−8𝑄=2𝑄⇒𝑄=25
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27. Determining the Optimal Level of a Control Variable
Economics of Effective Management
Determining the Optimal Level of a Control Variable
Total benefits
Total costs
Maximum total benefits
𝐶 𝑄
Slope = 𝑀𝐵 𝑄
𝐵 𝑄
Maximum net
benefits
Slope = 𝑀𝐶 𝑄
Quantity
(Control Variable)
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28. Determining the Optimal Level of a Control Variable II
Economics of Effective Management
Determining the Optimal Level of a Control Variable II
Net benefits
Maximum
net benefits
Slope =𝑀𝑁𝐵(𝑄)
Quantity
(Control Variable)
𝑁 𝑄 =𝐵 𝑄 −𝐶 𝑄 =0
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29. Determining the Optimal Level of a Control Variable III
Economics of Effective Management
Determining the Optimal Level of a Control Variable III
Marginal
benefits, costs
and net benefits
Maximum net
benefits
𝑀𝐶 𝑄
Quantity
(Control Variable)
𝑀𝐵 𝑄
𝑀𝑁𝐵 𝑄
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30. Marginal Value Curves Are the Slopes of Total Value Curves
Economics of Effective Management
Marginal Value Curves Are the Slopes of Total Value Curves
When the control variable is infinitely divisible, the slope of a total value curve at a given point is the marginal value at that point.
The slope of the total benefit curve at a given Q is the marginal benefit of that level of Q.
The slope of the total cost curve at a given Q is the marginal cost of that level of Q.
The slope of the net benefit curve at given Q is the marginal net benefit of that level of Q.
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31. Marginal Value Curves Are the Slopes of Total Value Curves
Economics of Effective Management
Marginal Value Curves Are the Slopes of Total Value Curves
A calculus alternative
Slope of a continuous function is the derivative /marginal value of that function:
𝑀𝐵= 𝑑𝐵 𝑄 𝑑𝑄
𝑀𝐶= 𝑑𝐶 𝑄 𝑑𝑄
𝑀𝑁𝐵= 𝑑𝑁 𝑄 𝑑𝑄
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32. Incremental Decisions
Economics of Effective Management
Incremental Decisions
Incremental revenues
The additional revenues that stem from a yes-or-no decision.
Incremental costs
The additional costs that stem from a yes-or-no decision.
“Thumbs up” decision
𝑀𝐵>𝑀𝐶.
“Thumbs down” decision
𝑀𝐵<𝑀𝐶.
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33. Learning Managerial Economics
Practice, practice, practice …
Learn terminology
Break down complex issues into manageable components.
Helps economics practitioners communicate efficiently.
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